The Shape of the Euro-zone Post Greek Elections

Highlights

The risk of an imminent Greek exit from the euro-zone has lessened with the conservative New Democracy party prevailing in Sunday’s elections. However, the market response has been lukewarm, as it remains to be seen how long a newly-formed coalition government will last.

A key issue for investors is what actions European policymakers need to take to keep the crisis in the periphery from spreading. Ultimately, Germany will have to assume responsibility for burden-sharing if the euro-zone is to be viable, but there is considerable uncertainty about when, and if, this will happen.

Meanwhile, the burden for supporting the euro-zone has fallen squarely on the European Central Bank (ECB), which stands ready to liquefy the financial system. It will also have to step up bond purchases of troubled European sovereigns to stabilize their yields, but the ECB does not want to let the national governments off the hook.

Against this backdrop, investors should be prepared for further declines in risk assets. With valuations at reasonable levels, we are prepared to ride out the storm rather than pare back holdings at this time.

Greek Election Results: Postponing the Day of Reckoning

Heading into the Greek elections on Sunday, investors had moved to the sidelines rather than anticipate an outcome that many considered too close to call. Fears that Greece could exit the euro-zone if the leftist Syriza Party prevailed were evident in the steady drain of deposits from Greek banks and assurances the ECB and the U.K. authorities made about actions they were prepared to take to limit any fallout.

With the conservative New Democracy prevailing in the election, a coalition government with the Socialist Pasok Party is the likely outcome. Assuming this happens, the probability of Greece making a quick exit from the euro-zone has diminished. The new government is expected to negotiate easier terms with the Troika (EC, ECB and IMF), particularly a slowing pace of deficit reduction. On this score, Greece will probably win some concessions, but the objective of a primary surplus of 4.5% of GDP by 2014 is likely to be maintained.p>

Thus far, the market response to the election has been muted, mainly because investors realize the coalition government faces a formidable challenge in reining in the budget when the country is in severe recession. Moreover, with a parliamentary government, there is no assurance how long the coalition will stay in power. In this respect, the latest election can be viewed as a respite for Greece to stay in the euro-zone before new challenges arise.

Meanwhile, market participants have refocused attention on Spain’s troubled banking system, where the government’s effort to recapitalize the system by borrowing from EU facilities has failed to reassure investors: Spanish bond yields have surged above the 7% threshold. The prevailing view now is that the Spanish government may be shut out of private capital markets, in which case it may have to fund itself eventually via the ESFS or ESM facilities.

Policy Actions to Stabilize the Euro-zone

In light of this predicament, we have been focusing on policy actions that are needed to stabilize the euro-zone. Last week, I met with several former colleagues from Wall Street, where this issue was discussed. The consensus that emerged was that resources would ultimately have to be transferred from creditor to debtor countries, and Germany was the only country capable of backstopping the euro-zone.

There was considerable difference in views, however, about whether Germany would assume this responsibility. Those who were the most pessimistic feared that German politicians were too intransigent and would only respond belatedly. John Lipsky, by comparison, was more optimistic that Germany was prepared to do what it would take to keep the euro-zone (and the single market) intact. However, he indicated that Angela Merkel first wants to be sure that the respective deficit countries will undertake structural reforms to set the stage for a true fiscal union. In his words, “One leader in Europe is playing chess (Merkel), while the others are playing checkers.”

At a dinner in Montreal that evening, former Fed Chairman Alan Greenspan presented his views about the euro-zone, which were very bleak. Greenspan’s main message was that the political and cultural differences between Northern Europe and Southern Europe were too great to be bridged. In his view, the likelihood is that the euro-zone may ultimately collapse. When queried what he would do if he was asked to manage money for a client in these circumstances, Greenspan’s answer was that he would return the money to the client and tell him to spend it on a party!

Central Banks to the Rescue

While most investors are not holding their breath waiting for decisive actions by European governments, markets nonetheless rallied last week in anticipation that the ECB and other central banks would respond by providing additional liquidity to the global financial system. The question which this poses, in turn, is whether such action will be effective.

A recent report by BCA research entitled “Trust Everybody, But When to Cut the Cards?” (June 15, 2012), concludes that monetary reflation may not be able to solve Europe’s woes, but it can buy time for policymakers to act:

“Although stocks are falling, we should not forget that the world may be on the cusp of another important reflationary impulse. China’s central bank has eased and more rate cuts will soon follow. The Federal Reserve is also ready to do more. With the Spanish banking system teetering on the brink, the European Central Bank is under enormous pressure to ring-fence the entire system.”

According to BCA, if the ECB wants to put an end to the crisis it can do so by buying up distressed sovereign debt until yield spreads narrow sufficiently. BCA points out that the Fed has acted as the ultimate guarantor for liabilities of the U.S. government while the ECB has refused to take on that role for European sovereigns: “The Fed owns 19% of outstanding treasuries and 50% of the stock of MBS, but the comparable figure for the ECB is 6%.

At the same time, BCA anticipates that the ECB under Mario Draghi may be different from what it was under Jean-Claude Trichet. First of all, Draghi has made it clear the ECB stands ready to stabilize the banking system if there is any panic attack. Second, he responded to the crisis last autumn by engineering the 3-year LTRO, which is the largest balance sheet expansion in the ECB’s history. Third, the stakes are even greater today and there is heightened urgency to take strong action in the wake of the problems in Spain’s banking system.

My own take is that Draghi has emerged as a strong leader and will do what it takes to keep the European financial system intact. However, he has also indicated that the national governments must do their part to reform their economies and financial systems, rather than rely on the ECB to make their jobs easier.

Investment Implications: Riding Out the Storm

Faced with this situation, many investors feel torn between paring back on risk until the European authorities have taken decisive action versus staying in the markets and riding out the volatility. Previously, we responded to developments in the euro-zone (and the global slowdown) by paring back on high yield bonds in fixed income portfolios and by increasing cash holdings in equity portfolios. In our view, the trade-off between risk and return for these asset classes is now evenly balanced. Accordingly, we have decided to maintain existing positions for the time being.

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